Thursday, October 22, 2015

Naïve Asset Allocation

Of course naïve is just Evian spelled backwards,

From the CFA Institute blog:

Dumb Alpha: The Ignoramus’s Guide to Asset Allocation

Modern finance constantly busies itself with the development of new, more sophisticated ways to manage risk and generate returns. These efforts, however, generate their own risks — for example, overspecifying a model or falling prey to data mining. On the opposite end of the spectrum are simple ways to invest that have a proven track record of providing superior investment outcomes. This article focuses on investment techniques that are so simple it is surprising how well they work, a phenomenon that Brett Arends ofMarketWatch has called “dumb alpha.”

The Dumb-Smart Way to Think about the FutureAssume you are a middle-aged man with a receding hairline and an expanding waistline. In short, you don’t look like George Clooney — you look like me. Moreover, you need to finance your retirement with your savings. Creating a portfolio to build retirement wealth is no easy feat given the fact that retirement may be 20 to 40 years in the future. A lot can happen in that time: 30 years ago, Japan was on its way to overtaking the United States, China was a closed-up Communist country, Europe and North America had broken the spell of runaway inflation, and Brazil was a basket case. Who can say what the next 30 years will bring?

Luckily, you are well aware that it is nigh impossible to predict which investments will do well during the next three decades. And assuming this is true, there are only two logical ways to invest.

One possibility is to hold all your savings in cash or the safest short-term bills and bonds. The problem with this approach is that you will have a hard time keeping pace with inflation once taxes and other expenses are taken into account. And in some countries, like Germany and Switzerland, you even face what my colleague Will Ortel calls “unterest rates.”

The other possibility is to invest the same amount of your money in every asset class. This makes sense because you don’t know how stocks will do compared with bonds or real estate investments, or how Apple stock will do compared with Barry Callebaut. The simplest example of this naive equal-weighted approach would be a portfolio split 50/50 between stocks and bonds. Another approach would be to invest one-quarter of your assets in cash, one-quarter in bonds, one-quarter in equities, and one-quarter in precious metals. Similarly, instead of investing in a common stock index such as the cap-weighted S&P 500 Index, you could evenly spread your precious funds across all 500 stocks of the index.

The Advantages of a Naive Asset AllocationAs it turns out, this way of investing tends to work extremely well in practice. In their 2009 article “Optimal versus Naive Diversification: How Inefficient Is the 1/N Portfolio Strategy?,” Victor DeMiguel, Lorenzo Garappi, and Raman Uppal tested this naive asset allocation technique in 14 different cases across seven different asset classes and found that it consistently outperformed the traditional mean–variance optimization technique. None of the more sophisticated asset allocation techniques they used, including minimum-variance portfolios and Bayesian estimators, could systematically outperform naive diversification in terms of returns, risk-adjusted returns, or drawdown risks....MORE